We Study Billionaires - The Investor’s Podcast Network - TIP 062 : Warren Buffett's Favorite Book, Security Analysis (Business Podcast)

Starting point is 00:00:00 We study billionaires, and this is episode 62 of The Investors Podcast. Broadcasting from Bel Air, Maryland. This is the Investors Podcast. They'll read the books and summarize the lessons. They'll test the waters and tell you when it's cold. They'll give you actionable investing strategies. Your host, Preston Pish, and Stig Broderson. Hey, how's everybody doing out there?

Starting point is 00:00:31 This is Preston Pish, and I'm your host for The Investors podcast. And as usual, I'm accompanied by my co-host Stig Broderson out in Denmark. Stig and I are reading a really long book right now. And we just finished up our last episode with Tren and talking about Charlie Munger and we're reading a really long book. And so we needed a little bit of extra time to be able to get through that book. And so Stig and I were saying, you know, which books have we read in the past that we could do an episode on? And the one book that kind of came to mind was this book called Security Analysis. I know there's a lot of people out there that are always hearing us talk about the book security analysis. But today's episode, we're actually

Starting point is 00:01:08 going to go into a little bit of depth to talk about what we actually know about this book. So before we start diving in and talking about this particular book, I think it's really important for us to give the proper amount of context for people to understand what it is that we're about to talk about today. Warren Buffett has a quote saying that security analysis, the intelligent investor, and the wealth of nations were three very, very influential books shaping his life. He also has another one that he's read called Common Stock and Uncommon Profits by Phil Fisher. He says that that makes up about 15% of his investing philosophy as he's broke that down into a percent. But the one that we're really going to focus on, as I said, is security analysis. So I want to start off by reading the

Starting point is 00:01:51 forward insecurity analysis, which is written by Warren Buffett. The book starts off and it's four or five paragraphs here. So I'm just going to read it. read the whole thing and let you guys hear it directly from Warren Buffett's quote. So this is Warren Buffett's Forward. There are four books in my overflowing library that I particularly treasure. Each of them was written more than 50 years ago, although would still be of enormous value to me if I were going to read them today for the first time. Their wisdom endures, though, their pages fade. Two of those books are first editions of the wealth of nations by Adam Smith, and that was written in 1776, and The Intelligent Investor by Benjamin Graham written in

Starting point is 00:02:30 1949. A third is an original copy of the book you hold in your hands, Benjamin Graham and David Dodd's security analysis. I studied from security analysis while I was at Columbia University in 1950 and 1951 when I had an extraordinary good luck to have Ben Graham and David Dodd as teachers. Together, the book and the men changed my life. So he keeps going into, he keeps going here. There's a little bit more.

Starting point is 00:02:55 But at the very end, he says, and so the fourth book was a very special edition that David Dodd's daughter gave to Warren Buffett and it was the original handwritten notes that David Dodd had of this book. So that just shows you how much this book really means to Warren. And it's pretty amazing to know that he got the original copy written by David Dodd. So a lot of people don't know David Dodd's influence on the book. But David Dodd was basically like a teacher's assistant to Benjamin Graham. He assisted Benjamin Graham.

Starting point is 00:03:25 And when Benjamin Graham was giving his lectures in class, David Dodd was really going to doing the Nug work and working very hard to write down everything and make sure it was all captured and then it was compiled into this book. So that was really David Dodd's role. A lot of the thoughts and a lot of the ideas of how Graham thought, those were all Graham's ideas really for the most part. From my understanding, those were Graham's thoughts. And David Dodd was more of a scribe whenever you look at security analysis.

Starting point is 00:03:52 Now, I'm sure David Dodd had some of his own thoughts that he put in here, but for the most part, a lot of people out there attribute most of the ideas in this book to Benjamin Graham. So that's kind of really the start. Now, the book that I purchased whenever I first started learning, and my poor book here is literally falling apart. And they can attest, I'm showing it to them over the screen. You can see the pages are literally falling out because I reference this thing so much. And I've got so many handwritten notes through this thing. I just love this book. This is hands down one of my most favorite and prized possessions.

Starting point is 00:04:25 But aside from that, when I got my first book, I got the sixth edition of this book. And that was kind of a mistake, to be quite honest with you. I didn't know any better. And in the sixth edition, they took out a bunch of the chapters in this book. I don't even know how many chapters were taken out, but it's a lot. And that was one of the things that I didn't know whenever I purchased this, that they had removed a lot of the chapters from the original book. And the book is still huge.

Starting point is 00:04:51 I don't know how many pages is this thing. 766 pages. Yeah. Yeah, they probably just took out the tetest that the new no one would read or. Yeah. All these ones on the speculative features and that kind of stuff. They just totally axed them out of the book. Now, what you'll find is they gave an accompanying CD that came with the book.

Starting point is 00:05:11 Yeah, I'm looking here in part two. There's one, two, three, four, five, six, like six chapters that aren't even included out of the, you call it, 10 or 15 chapters for that section. So that's really frustrating to me that you don't have a hard copy of that. Now, where it really came in useful, though, is they gave you a CD that's attached to the book. The CD comes with the book, and it's a PDF of the entire book. It doesn't have those chapters removed off of the disc that you got. And so in a way, that's where the sixth edition, I really liked it because I could search for terms through the PDF file. I could search for things that really saved me a ton of time instead of trying to flip through the book or find

Starting point is 00:05:52 where I had tabbed it for certain notes. So that's one nice feature about the sixth edition. So there's the give and take if you're trying to decide which version of security analysis to buy. So anyway, Stig and I, a lot of people might not know this, but Stig and I wrote an executive summary of this book because it is so difficult. I remember the first time I tried reading this, I was like, what in the world is in this book. And it was very difficult for me. And to be honest with you, the first time I tried to

Starting point is 00:06:23 read it, I didn't read it at all. I was really struggling and knew there was really important information in it, but I didn't understand the terminology. And I think that that's probably the most important thing I tell a lot of young investors when I'm talking to people is I tell them, learn the terminology. Stig, you'd like to use the reference of traveling to another country and not knowing the language. And I think that's a fantastic example. I'll let Stig say. It's a great example. Yeah. So the way that initially I looked at security analysis, whenever Preston came up with this amazing idea that we should write the summary of the security analysis, he said that yes, and Preston, that's literally the case for me because in nine months from now, I will actually

Starting point is 00:07:09 be moving to Korea and I don't know how to say anything in Korean. And so I'm very worried about that. And I guess that's the same feeling that people have whenever they open up security analysis. I know at least from my perspective, I felt like I was a foreigner in a new land. And this was definitely not the first investment book I read security analysis. But it was by far the hardest in that part of time because not only was using a lot of words that I had no clue what meant, but he was also using a lot of different words for the same thing, which is not what you're looking for when you're looking at a additional book.

Starting point is 00:07:46 And I don't know if it was just me, but he was not consistent about which words that he would use for the income statement. Then it was the income statement or income account or the profit and loss or whatnot. So just remember, I was very confused. And I remember back then you said that, you know, Stake, I know that we will go into write this book. and I'm sure it would be a great book, but just know that no, I want to buy this. You told me the dividends was really that you would grow your knowledge. And definitely the latter is true. Well, so he's exactly right.

Starting point is 00:08:21 When we wrote this summary guide, it was a little bit more for ourselves than really selling it, to be quite honest with you, because we wanted to basically ensure that every word in every chapter of this book is something that we fully understood. And I know when I was going through this and I'm writing a summary guide to help people break this down into simple and plain English. There was many times. I was looking up terminology saying, wow, I don't even know what this term is. And I would have to look it up and be like, oh, this is just like a different term that's been used in the past or something really basic. But that's the big hurdle here. And what was really nice and it talks about how ambitious I can sometimes be with myself.

Starting point is 00:09:03 I'm reading about Warren Buffett, and I read this line that says, Warren Buffett learned everything he knows from this book security analysis. And so me as the person who's just maybe a little over-ambitious at times, like, oh, well, that's simple. I'm going to buy that book and read it and totally understand it. So I buy security analysis. It comes, and I start going through it. And I'm like, what in the world is this saying?

Starting point is 00:09:25 And you know what, in a way that was really good because it created this enormous challenge for me to actually try to figure out what this book was all about. And so for me, finally writing this summary with Stig on security analysis, it's called the 100-page summary of security analysis. It's on the Amazon, if any of you guys are interested in it. But when we were done, it wasn't even close to being 100-page summary. It was like 220 pages or something like that. And let me tell you, we summarized the live and pulp out of this book, and it was still a 200-page summary. But it's still called 100-page summary.

Starting point is 00:09:59 I like that. That's right. That's right. It is. But just so people know, our intent in writing that was really to make the language of this book more understandable, just more comprehensible. Now, where we kind of weren't able to go into a lot of detail is the thing that you'll learn about security analysis, Ben Graham was like the master of using real world examples to demonstrate an idea. So he would come up with an idea about, say, something on the income statement. What Ben Graham would do is he'd go out and he'd find five to 10 to 15 different companies. and he'd say, these are all the points that I'm trying to make, but you're seeing it through real-world example companies on the market today back in the 1930s. And he would represent those ideas with real-world examples.

Starting point is 00:10:46 And that's what really, I think, set Ben Graham apart from any other financial investment author out there is he did some really hard work showing quantifiable facts backing up his opinions. So that's where, I think, Stiggin, our summary, we really do. didn't cover the examples. And I think when you cut a lot of those examples out, you free up a lot of space, and you just get to the idea. And that's what we were really trying to capture in our writing and trying to understand this. Yeah. And I real thing is a good point, Preston, because some of these examples are really complicated. I mean, really, really complicated. So for one thing, he talks about

Starting point is 00:11:22 how to value the investment portfolio of another company and how that is measured, how that is accounting for in their financial statements, which is, by the way, different accounting rules that you use today. What I think is really interesting because Preston and I, what we're doing right now is is reading a book called Buffett the Making of an American Capitalist. A great book, by the way, it's a long book, but it's a great book. And what you can see in that book is that Warren Buffett actually did the same thing. And I think he actually got that idea off security analysis.

Starting point is 00:11:51 He was actually buying another company that had this huge investment portfolio and forced that company to sell all those securities. and distribute that as dividend to the shareholders, just as he had read in security analysis. And I'm just going to say this is not an easy process to do, to value this investment portfolio, then to take control over the company and start distributing out to the investors.

Starting point is 00:12:14 I think that was an amazing accomplishment from Warren Buffett. I almost feel like it was not a Warren Buffett type of deal. It's more like a Kyle Icon kind of thing, like an activist approach. But in that sense, I also think that Benjamin Graham had really activist style of doing it. And there was something that Warren Buffett did in his early years. So what I want to do at this point is really kind of just talk about the key points that are found in this book and the layout that Benjamin Graham chose to go through this book.

Starting point is 00:12:40 There's no way we can get into the specifics of some of the ideas that are discussed in here. We do that in the summary. But to talk about it over the podcast is going to be very difficult to make any kind of sense. But what I do want to do is I want to break out and talk about the different parts that the book is broken down. to so you can kind of understand what's inside of it and what there is. So the book starts off. There's part one. It's five chapters long and it's called survey and approach. And this is where Ben Graham really kind of lays down the law from a very high level site picture where he really talks about this idea of intrinsic value, talks about these ideas of risk, talks about the different asset classes,

Starting point is 00:13:21 whether you're talking about stocks, which is also called equities, or fixed income, which is commonly referred to as bonds. And he basically shows the reader where those fall. So when you're buying equity or you're buying stock, that sits lower than the architecture of owning a bond. You have a higher stake or a higher claim inside of that architecture in the event that the business would go bankrupt. So what's important as you're talking about bankruptcy, because that comes up a lot with Benjamin Graham. And the reason it comes up is because this book was published in 1934. So let's think about the context of what Benjamin Graham was writing about because you talk about the deepest and darkest part of the Great Depression. You're talking about those early 1930s, really specifically, I think the deepest was 1933 when they came off the gold standard.

Starting point is 00:14:10 So you think about when they would have been writing this. They would have literally been writing this book right in that time frame when it gets published in 1934. So that's where he was seeing the world is, hey, how can you protect your interest in whatever you're investing in? And so he would talk about, hey, if you own a bond and you own stock and the company goes bankrupt, guess what? The first person to really lose their money in the grand scheme of things is the person holding the stock. The next person is the preferred shareholders. The next person is the bond.

Starting point is 00:14:41 Then you get into the banknotes and things like that. It really kind of takes shape from this really big idea of you got these companies and you got intrinsic value, you got inherent risk, you got these different asset classes. He breaks that down in really the first five chapters. Let's take a quick break and hear from today's sponsors. All right. I want you guys to imagine spending three days in Oslo at the height of the summer. You've got long days of daylight, incredible food, floating saunas on the Oslo Fjord,

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Starting point is 00:19:00 slash WSB. All right. Back to the show. What I really took away from this first part was how he distinguish between investment and speculation. And I actually also think that we have to talk about the concept, as you were talking about before present, because this was just right after the Great Depression. And he would say, like, multiple times that even cautious investors might be looked at as speculators. And this was actually a concept that he addressed again and again different additions also, that depending on the my condition, sometimes speculators were almost looked as investors.

Starting point is 00:19:38 And then in times like 1934, when he published security analysis, even a very cautious investor like Benjamin Graham, who was by the public considered almost like a gambler because he was something called stocks and bonds. And then the public opinion just suddenly shifts. And I think that's really interesting also because that is basically what you see today. I'm sure that most of us remember what happened before the financial crisis. Like so many people were just considered geniuses because they borrowed a lot of money and bought some real estate. And then you couldn't say that you were investing in bonds or stocks of real estate after the crash because then you were a speculator and you were so dangerous what you did. You were an idiot.

Starting point is 00:20:19 I'm not saying that. Honestly, I'm saying that because the perception that a lot of people had at that point shifts like that. And that's a fantastic point. And that's a huge, huge Benjamin Graham thing. He talks about it in the start of this book. You go to the intelligent investor. that's the very first thing he talks about. What's investing versus what's speculating?

Starting point is 00:20:40 And that is a key concept that he, either you agree with him or you don't agree with him. And if you don't agree with him, you don't want to read another word because it's all based on that fundamental idea. And so that's where he starts getting quantifiable, which really had never occurred before this 1934 edition came out where people was very speculative. It's like, well, that's going to go up. And here's a couple reasons why where Benjamin Graham was saying, hey, you got this thing called the balance sheet, and then you got this thing called the income statement,

Starting point is 00:21:10 and then you've got bonds, which, and the way he describes and fits and pieces all of this together, for anybody that's watched the videos that I made for the Buffett's books, that's where all those videos really came from, was reading this book, fully understanding the ideas in this book, and then trying to piece it together in some type of format that was comprehensible for people to really understand how Benjamin Graham had pieced all those together. So let's go to the second part of the book. And in the second part of the book, Benjamin Graham starts off talking about fixed value investments. So he's talking about bonds.

Starting point is 00:21:43 And how many chapters are there? 15 chapters on bonds. And so he starts off in the book, if I remember right, he starts off in the book and he says, you know what? One of the biggest banks in New York is using this method to basically value fixed income securities, which are bonds. why not use that same method as an investor, as an individual investor? Why wouldn't I look at it through the same context? And so he uses that as a framework. He goes and he basically dissects

Starting point is 00:22:12 how this big bank uses the risk management to invest in bonds. And then he takes that on as an individual investor. And what's really interesting is he says, this I totally agree with, this I don't agree with. And these are all the reason why. And these are all the examples why. He just gives this overflowing amount of information describing why he does or doesn't agree with their approach into valuing a bond in a particular manner. It's quite comprehensive. It is amazing to go through. Like I said, it's hard at first if you don't understand the terminology.

Starting point is 00:22:46 But once you get that terminology, you have such a deep appreciation for what he's doing and how in depth he's going on that analysis. Just one more thing on the terminology thing. Warren Buffett has a quote that says that accounting is the language of business. He says, if you don't know that language, you're really off through the wrong footing and the wrong step that you don't have the foundation to really step in there and really know what you're talking about. So just one more emphasis on how important the terminology is to understand because you're never going to tackle a book like this unless you understand the terminology.

Starting point is 00:23:17 Now I'm really worried about going to another country. No, I don't know. It's a bad joke. No. So I was completely blown away whenever I saw a the second part of this book because I knew what a bond was and I was kind of like that might be a chapter or two but as president is saying that was 15 chapters and he's not just talking about bonds he's talking about all types of fixed income maturities and how that deviates and how that's different in the railroad business how that's different in the utilities business and he is so comprehensive in everything he does in this chapter but I think I want to point out two things about the second part here the first one is that he really talks about how

Starting point is 00:23:55 how the issue of a fixed income security is really whole key here. You need to be able to dissect and to really understand who is the issuing that the security and then figure out what's the risk. You talk a lot about risk and it's so important because you don't get any of the upside whenever you have a bond. If you're lucky, you actually get the coupon from that bond. It's not like if the business is doing well, you get more money. So he talks a lot about that and he's very philosophical and it really attacks this from many

Starting point is 00:24:24 angle so he's saying well is it actually safer for a company if it issues bond in a low interest rate because then your coverage ratio you higher meaning that the cost that they would have to the debt would be lower does that mean now it's more safe bond think it's so important really to understand whatever you buy a bond it's really an iOU and if you don't understand who the issue is really fully grasp that you're just starting off with the wrong wrong foot and you should always look at the risk for you, you think about the return. A topic that comes up a lot about this book, and I get asked this question a lot, is, is that book even still relevant? It was written back in the 1930s. Why do I really need to read that?

Starting point is 00:25:09 It's so out of touch with the current markets today. Boy, I'll tell you, I couldn't disagree with that idea more. When I look at books today and new modern versions of this book, I'll tell you, folks. My opinion is that this book is so relevant today. I just so disagree with that. I'm curious to hear your opinion stick. I'm assuming you agree with me. Well, yeah, generally, I agree with you. I think the book is irrelevant for some types of investors. I definitely think that the intelligent investor, which is more, let's call a more simplified version of security analysis, that's important to understand for all investors, like 100% of all investors out there. But I think for security analysis, the way it's written and all the part,

Starting point is 00:25:52 I think if you're an active investor, I think it's important to understand all these things. If you're a passive investor or what opinion of grand costs defensive investor, you might be okay by only reading the intelligent investor. At least that's my opinion. You need to have a really profound knowledge about investing before starting security analysis. That's for sure. All right. So let's go ahead and move into the third part. And the third part of the book is titled Senior Securities with Speculative Features.

Starting point is 00:26:19 This part of the book has five chapters. And this was a really interesting one for me because really you're not exposed to a lot of this stuff when you're talking about privileged issues. And this is when you get into things that are convertible, participating, and subscription-based bonds and preferred shares. So it's kind of something that a lot of people don't talk about. A lot of people don't really understand. And I think that this section here was really important for me to just read and try to

Starting point is 00:26:47 understand for the first time. And it was really quite interesting as you go through it. What's neat when you're going through some of these more privileged type securities, you get into combinations, I guess, is the best way to put it, where you're mixing equities with fixed income and you're talking about how you can convert those from one to the other. And that's what this is really going to into. And to tell you, it's really helped me out as a business leader and as a business manager. And when I'm looking at things because I'm constantly trying to understand, first of all, how an asset is structured, but more importantly, how can I be more creative with the way that it's set up so that it accounts for the time function, the growth function, and things like

Starting point is 00:27:30 that as you're looking through the progress of how a business might progress. Something that's really quite interesting, whenever I watch a show like Shark Tank, and you're watching these guys who are definitely on their A game, structuring a business and structuring the equity of, I'll do this as venture debt, and I want a convertible into equity. That's what they're doing. That's what they're really kind of setting this up for, where they're minimizing their risk

Starting point is 00:27:53 and they're setting it up so that the original founder, the business might have an advantage up front, but then they lose that advantage as time progresses and they actually show maturity and show growth within the company to produce revenue and net income, their bottom line. So really quite fascinating read, and I think that it's probably something that people will really struggle with whenever they would try to do this initially,

Starting point is 00:28:14 but as maybe their knowledge progresses, it's going to be something that they really value and look at a lot more. I'm really happy to you that you said the last thing, Preston, because I don't know of any author of the book that discourage potential bias of the book as much as we're doing. So what I really took away from the third part here was,

Starting point is 00:28:35 first of all, how advanced it was, to be quite honest, but also how Warren Buffett has applied a lot of the same principles today. And the first thing that comes to mind is an investment in Bank of America. So what Warren Buffett did with Bank of America was that he bought $5 billion worth of preferred stock. Preferred stock, that's sort of something that's between a stock and a bond. So it's something that would give you a coupon, but you will not necessarily get the same upside as you would with that stock. I'll make sure to link a video where Preston actually explains this a lot better in 10 minutes with some example.

Starting point is 00:29:10 So there's a better example than what did, but just think about someone in between and think about it like that you're getting a coupon. So Warren Buffett, he's getting 6% of those $5 billion. But at the same time, he has the right, or this is called a warrant, by the way, it's something that's issued by the company. So Bank of America had given him a warrant to buy 700 shares of Bank of America and an exercise price of $7.14. So at any point of time, he convert this to add a price.

Starting point is 00:29:40 is $7.14 cents to Bank of America. I love that point stick. And I got the same exact opinion whenever I did this. And we've never talked about this before. But I got the same exact opinion when I was reading through this part of the book. And I'm saying, this is exactly what he did in 2008. And the example that really kind of I remember was Goldman Sachs. So he did a preferred stock buy from Goldman Sachs. I think he purchased about $5 billion worth of preferred stock that yielded a 10% dividend, which just so people understand the simplicity of preferred stock, it works almost identical to a bond. It's almost exactly the same as a bond. So he purchased this preferred stock. And it's not the same, but it's really close to being the same.

Starting point is 00:30:25 So for simplicity stake, that's probably the best way for you to understand it. But he purchased this. If I remember right, the book value that he purchased a preferred stock at was $115 a share. And if you go back and you look at the book value of the common stock on Goldman Sachs at that particular point in time back in 2008, if I remember right, it was around $115 a share. So he locked that in and then they were paying a 10% dividend on that preferred stock. So he's collecting that dividend. Then he has the option to convert it into common stock. I think he had to hold the preferred, I think the convertibility could occur at five years. So the beauty behind this move that he did back in 2008, because people really didn't understand.

Starting point is 00:31:05 understand what he was doing and why he was doing it that way, was he had the opinion that Goldman Sachs was going to come back to being worth a whole lot more or a premium to that book value of $15 a share. That was his opinion, I'm assuming. And so he didn't know how long it was going to take for it to get there, but he knew it was going to ultimately and eventually get back to a value above that 115 mark. But he didn't know when it was going to occur. So his opinion is, hey, let me lock in a 10% dividend over the next five years.

Starting point is 00:31:34 if the stock starts going crazy and starts going higher, well, I'm actually holding that value, but it's being masked behind that preferred stock value or that dividend then I'm receiving that 10% dividend. But I can convert it into common stock at any point in time. So I don't know what Goldman Sachs is at right now. I would assume it's well over $200 a share. I could look it up. And Steger, you looking it up? It looks like you are, yeah. And so what he did is he was able to lock in that equity growth on the common stock. He's not in his head. What is it? Stick. I'm curious. Well, $197. Boom. Hey, that was close. That was close. That was close. Three dollars off. Okay. So he locked in that price and he was able to convert that over to common stock whenever he

Starting point is 00:32:18 felt was right and the time was necessary. But think about that. He locked in a 10% dividend on $5 billion. So he's making $500 million a year on the dividend as he sits around and waits for the equity to mature, and he bought these for $115 a piece. I believe that was the price. You'd had to go back and look, but I think that was the price. And so he almost had 100% growth on the equity. That's what he learned from this third part in a book where you're talking about these senior securities with speculative features. He read this book. He understands these ideas, and he applies these ideas. And it's hard to really find some of these investors that you see on TV. I'm not going to name people. But you really really, you really.

Starting point is 00:32:59 I really don't see people like that talking about these really amazing. I mean, you can see why this guy's a prodigy at this stuff. And you don't become a prodig without reading this kind of stuff. And so Stig's point is just so fantastic. And I really, I'm so glad that he brought that up because that probably describes this part of the book probably better than anything else in a real example that people can really kind of digest. So with that said, we're going to go ahead and move on to the next part because we're getting

Starting point is 00:33:25 a little long. And the fourth part of the book, he goes into it, the title of this is theory. of common stock investment, the dividend factor. And there's four chapters for this that are talked about in this section. And really what Graham's getting at here is he's just talking about stocks that pay a dividend. And, you know, Graham is really big on only buying companies that have a dividend. Now, Warren Buffett has really ventured away from this idea where he doesn't necessarily need to receive a dividend. In fact, I would say he might even prefer to not get a dividend because of the tax implications and things like that for the business. But Graham had a different approach

Starting point is 00:34:02 and Graham really favored the dividend. If a company was holding too much retained earnings from what they had profited over the years, he was a big proponent that that should be released back to the shareholders through a dividend. And so he talks about some of those ideas in this fourth part. Let's take a quick break and hear from today's sponsors. No, it's not your imagination. Risk and regulation are ramping up. And customers now expect proof of security just to do business. That's why VANTA is a game changer. VANTA automates your compliance process and brings compliance, risk, and customer trust together on one AI-powered platform. So whether you're prepping for a SOC 2 or running an enterprise GRC program, VANTA keeps you secure and keeps

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Starting point is 00:37:40 Well, I also think it was a safety issue because it's really, really hard to manipulate your financial statements if you're paying out dividends. if you're paying out dividend. Well, you can still do that, but if you're consistently paying out dividend, you have that safe amount of cash flow flowing out to you. And what you see not only in this section, but in all the other sections, is that Mnman Grant tells you about how so many companies have been manipulating all their statements to really appeal like they have a lot of assets or have a lot of earnings, but they really don't have.

Starting point is 00:38:12 So I think that's why he favors dividend. And I don't know if you live today in the environment that we have today, if he would favor it the same way. I just think it was a way of protecting himself. And I also want to say that at that point of time, the yield that you get on dividends was just phenomenal. He's talking about very generous double digits dividend yield for, you know, safe, stable companies. And you don't see that today. Yeah, and I think there's been a major change, and we can talk about this real fast. I think there's been a major shift in the thought of business, which I agree with.

Starting point is 00:38:43 I think as a manager of a business, you want to have a certain amount of retained earnings for that asset that you might need to purchase because the market is just so competitive these days. If you don't have that war chest at your disposal, somebody could come in with a competitive advantage and knock you out of the race so fast and make your headspin. And I think that's why you've seen this shift where it's more acceptable for business leaders to retain a lot of their earnings on their balance sheet in the event that they do need to go toe to toe with a competitor. Back whenever Graham wrote this, I don't think that that was necessarily the going concern and the going thought process. It was more, hey, pay the owners of the company, which are the

Starting point is 00:39:24 shareholders, and move out and keep, you know, sucking whatever earnings or profit that those assets can produce out of them. And at this point, we'll go into the fifth part of the book, which is the analysis of the income statement and the earnings factor in common stock valuation. So at this point in time, this is where Graham jumps from talking about basically bonds and fixed things. income and the speculative features of fixed income. And he's making that jump over into common stocks. He does that around part four, part five of the book. So just to give you an idea, that's right around the 400 page mark of the sixth edition. If you were looking at the second edition where it's the full length and all these chapters aren't cut out, I'm sure to be even

Starting point is 00:40:03 deeper into the book. Just to give you an idea of how much he talks about fixed income securities before he even gets to common stock. So when we get to the fifth part, this is where he talks about the income statement. So anyone that's gone through our Buffett's books videos, they know that we've got the income statement, we've got the balance sheet, and we've got the cash flow statement. The cash flow statement wasn't something that even existed when Benjamin Graham wrote this book, so it's not even discussed. I love talking about the cash flow statement, so it's kind of interesting to know that that wasn't even something that was available back whenever he wrote this. But here in the fifth part, that's whenever he starts talking about the income statement. So let me break down the income

Starting point is 00:40:40 statement for anybody out there listening that doesn't know what this is. The income statement is like looking at your checking account, okay? You could look at all the money that's come in, and that would be your top line, and that would be called your revenue or your sales. It has some different terminology, and that's where things get a little bit tricky. But think of that as your top line. That'd be all the money flowing into your checking account. And then if you could take all those receipts and everything that you've spent coming in and out of that checking account, and you added all that up what was left at the bottom line. That would be called your net income. And that's really the profit that the company has produced for the year. And that's probably the easiest way, simplest

Starting point is 00:41:17 way. I'm sure it's not 100% a matchup to what the income actually represents, but it gives people an idea of what an income statement is for a business as you would look at how they function. So it's really important. As you look across all the companies on the stock exchange right now, and you were able to pull up all their income statements, what would you say the percentage is Stig that people would, I'm sorry, not people, but companies would actually have a positive number for their income statement. I would guess 60% somewhere around there. Something around that, yeah. So out of all the companies on the stock exchange, only 60% of them would have a bottom line that's actually profitable. And I think for a lot of people, that might blow their mind.

Starting point is 00:42:00 They might not even realize that, but that just shows you how difficult and how competitive it is out there to turn a profit, to even have something that's profitable. Now, that doesn't mean that they haven't been profitable in the past. I'm just saying right now, time now, you could probably look across the stock exchange and about 40% of companies aren't even turning a profit. So that's what the income statement is. It's telling you, is this company profitable? And if they are, what's that number?

Starting point is 00:42:24 What's that bottom line number? I think if there's one thing you can really take away from this book, which you probably can find in the literature out there, at least that's my experience, is how he looks at earnings and the very detailed approach he has to figure out what's the true earnings of this company. I think all the other content that's out there, they're saying something like, well, you should probably just take the average. Well, that's not good enough for Benjamin Graham. He's really talking about how to look at each line in the income statement or a cash flow statement for that matter, even though it wasn't invented back then and says how can you figure out what's the true earnings. Now, he is saying that still it is a qualitative calculation you have to do. It's not a finite calculation, but I think the way he approached this is really worth buying to courage analysis for because he's so detailed about that. I do want to say one thing, though, if you're reading the original version, a lot of the practice that is critical.

Starting point is 00:43:21 criticizing. That's not legal anymore. So don't think that corporate America are more corrupt than you might think in your analysis. That's a good point. And I want people to understand what Sticks talking about as far as saying, what's the real earnings? Okay. So let me give you a really basic example as I'm looking at the hardware that we use in order to do this podcast. So let's say that our company produces $10 of profit on the income statement. So that's the bottom line. There's $10 there. Now, in the past, we have purchased, like I'm looking at an iPad that does the sound at the beginning. I've got a big screen TV thing set up here. I've got a mixer board. We got a really nice microphone. So all that stuff costs money. Let's just say that it cost

Starting point is 00:44:06 $5,000 to have all this recording equipment. Now, let's say I wanted to sell all this equipment and I wanted to do something else with my company. So if I sold that $5,000 worth of equipment, would I get $5,000 first of all? And the answer is absolutely not because it's used. So let's say I would only get $2,500 for that equipment. Now, as I would carry that loss, because it's now, it was worth $5,000, I sold it for $2,500, so I would carry that loss over to my income statement because all those numbers, that $5,000, that $2,500, that was actually sitting on my balance sheet.

Starting point is 00:44:42 That was not sitting on my income statement. As I would sell that, that then moves off of my balance sheet onto my income statement and it materializes, it actualizes onto my income statement. So like we said, the net income, the profit was $10. Well, now I have a huge loss that I've got to write off onto that income statement of $2,500. So now it looks like I lost $2,490 for the year. You see where that happens. See, the profit was added to the negative there. And so it looks like I had this big loss, but in all actuality, that's not really the flow of my business that's creating that value. That was something that, an asset that I previously owned. So what he talks about in this section of the book where he's

Starting point is 00:45:23 analyzing the income statement, he's going into detail talking about, hey, although the company might have had earnings this year of this amount and the following year, this amount, this is how you really get down to what is the flow of money that is slowing through this company, which we commonly refer to now is what's the cash flow of the business? What's the free cash? the cash flow of the business. And that's what Ben Graham was trying to get at back in the 1930s. And this concept and this idea wasn't something that was readily available or anyone was even talking about it. But back then, Graham was. You just have a super quick comment here. So you might be thinking, so how would that apply

Starting point is 00:45:57 to a big corporation today? I think the best example I come up with was Starbucks back in 2013. They had a huge lawsuit from Kraft back then. And they raised basically all of their profits from that year. And what Benjamin Graham was talking about is that what is a one-time charge and what is a part of the general business? And you need to be able to distinguish between those two. If you only look at the bottom line at listed businesses, you're really heading for trouble. You must understand how are these earnings derived. So it's just a super brief example. If you want to look up on that on Starbucks and what happened in 2013, I would definitely just say we do. It's a really interesting case. But just to see how you can just find earnings disappear from

Starting point is 00:46:39 one year to the other and then behind the profitable the next year. That's all accounting, basically. So as we go into the sixth part of the book, this one has, it looks like another four or five chapters for this one, and this is all about the balance sheet. So the first one you talked about the income statement. I briefly talked a little bit about the balance sheet there. So those ideas would then be mashed into this six part of the book. Then as we go into the seventh part of the book, this is additional aspects of security analysis. And what he was really talking about this section is the discrepancy between price and value. So he has another seven chapters in this section, and that's a really important part because that's where he's throwing out all these

Starting point is 00:47:18 examples of what's this company worth with these different dimensions on their income statement and balance sheet. What I think a lot of people would not know, and a lot of people would think, is that there's some intrinsic value calculation found inside of this book. I think that really surprises a lot of people. But with that said, I think everyone can agree. I mean, you can pull up Warren Buffett's shareholder letters and the fine print he says that there's discount cash flow analysis that's done for him to determine the valuation of his equities or his stocks. So we know that the discount cash flow calculation is what he's doing. We teach two different methods for the discount cash flow on the Buffett's books website. So if you go there, you can look that up. But

Starting point is 00:47:59 here's the thing. There are a lot of different ways that people can calculate the intrinsic value through discount cash flow models. There's monstrous textbooks out there that just talk about different techniques for calculating intrinsic value. So I would highly encourage people to go out there, see what works for you. And in some cases, it's dependent on the company that you're looking at. You might have a company that's growing like a weed. Well, that's, you know, you've got to look at that a little bit differently than a company

Starting point is 00:48:24 that has a lot of stability, which is how Warren Buffett likes the value companies. So there's a lot of different methods. And I think for people just to get fixated on one, probably isn't good for you. I think it's important for you to learn all the different methods and all the different ways to really do that discount cash flow analysis. But, yeah, our website on Buffett's Books.com, has two calculators that you can use for that. We also have calculators for figuring out the value of a bond, figuring out the value of a preferred stock that's callable, all sorts of things like that. So we highly encourage you to use those tools. So really, that's all that we have for our review of security analysis.

Starting point is 00:48:59 just an amazing, absolutely amazing book. And you have to understand the terminology to do it. That's what we tried to really accomplish with our summary guide that we wrote. If there's a new term that's identified in the book, we try to describe what that term is. Or at least we like to try to explain things in a very simple language that's understandable for people. Because although Ben Graham was obviously brilliant, a prodigy at this stuff, I would say that their writing style is not the most conducive for people to try to learn if you don't have a very large, and robust foundation of understanding to start with. I want to tell people we have this tool on our Investors' podcast website.

Starting point is 00:49:39 Go to the link that we have on our website because you can download your first book for free. That is the key point here. You can download your first book. It doesn't matter what it is. It could be a $40 book. You can download it for free by using our link and signing up for your Audibles account. That's how we read all of our books.

Starting point is 00:49:55 All right. Well, that concludes our episode this week. We really want to thank everyone for joining us. and we'll see you guys next week. Thanks for listening to The Investors Podcast. To listen to more shows or access to the tools discussed on the show, be sure to visit www.com. Submit your questions or request a guest appearance to the Investors Podcast

Starting point is 00:50:15 by going to www.com. If your question is answered during the show, you will receive a free autographed copy of the Warren Buffett Accounting Book. This podcast is for entertainment purposes only. This material is copyrighted by the TIP network and must have written approval before a commercial application.

We Study Billionaires - The Investor’s Podcast Network - TIP 062 : Warren Buffett's Favorite Book, Security Analysis (Business Podcast)

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